February 28, 2019
Small business owners have several options for their retirement plans. Two tax-smart and flexible alternatives are SIMPLE IRAs and solo 401(k) plans. If you’re eligible for these types of plans and you want to maximize your tax-deferred savings, which makes more sense? Here’s a series of side-by-side comparisons to help you decide.
SIMPLE IRAs can cover self-employed individuals and small businesses with up to 100 workers.
Solo 401(k)s cover only the business owner and his or her spouse, if applicable. However, you can set up a garden-variety 401(k) plan if you want to cover other workers.
Annual Deductible Contributions
For both SIMPLE IRAs and solo 401(k) plans, there are two types of annual deductible contributions that can be made to your account. Both types of contributions reduce your taxable income if you’re self-employed or your company’s taxable income if you’re an employee of your S or C corporation. (A reduction in an S corporation’s taxable income is passed through to you.)
1. Elective deferral contributions. These contributions are completely discretionary. You can contribute little or nothing in years when cash is tight.
For the 2019 tax year, the maximum elective deferral contribution is the lesser of:
- 100% of your self-employment income or your salary, or
- $13,000 (or $16,000 if you’ll be age 50 or older as of December 31, 2019).
If you’re self-employed, you simply pay elective deferral contributions into your IRA.
If your business is set up as an S or C corporation, the company withholds elective deferral contributions from your paychecks and deposits them into your IRA.
For the 2019 tax year, the maximum elective deferral contribution is $19,000.
If you’ll be age 50 or older as of December 31, 2019, the limit increases to $25,000. This amount includes a $6,000 “catch-up” contribution.
If your business is unincorporated, you simply pay elective deferral contributions into your 401(k) account.
If your business is set up as an S or C corporation, the company withholds elective deferral contributions from your paychecks and deposits them into your 401(k) account.
2. Additional contributions
When you make an elective deferral contribution, you (or your company if you’re employed by your own S or C corporation) must make a mandatory matching contribution equal to the lesser of:
- 3% of self-employment income or your salary, or
- The amount of your elective deferral contribution (if any).
For up to two out of every five years, you can a make reduced matching contribution equal to the lesser of:
- 1% of self-employment income or your salary, or
- The amount of your elective deferral contribution.
As an alternative to making matching contributions, you can choose to simply make annual contributions equal to 2% of self-employment income or your salary, regardless of the amount of your elective deferral contribution (if any).
You (or your company if you’re an employee of your S or C corporation) can make a discretionary employer contribution of up to 25% of your salary or up to 20% of self-employment income.
The elective deferral and employer contributions (combined) generally can’t exceed 100% of your self-employment income or your salary (if your business is incorporated).
However, if you’ll be age 50 or older as of December 31, 2019, the combined contributions for 2019 can exceed 100% of your salary or self-employment income by up to $6,000.
For this purpose, self-employment income is defined as Schedule C, E or F net income reduced by the deduction for 50% of your self-employment tax bill.
In addition to the preceding limitation, the combined contributions to your account can’t exceed the annual dollar cap. For 2019, the cap is $56,000, or $62,000 if you’ll be age 50 or older as of December 31, 2019.
Important: With a SIMPLE IRA, for purposes of the elective deferral and matching contribution rules, self-employment income generally equals the net income shown on your Schedule C, E or F multiplied by 0.9235.
With both SIMPLE IRAs and solo 401(k) plans, you generally can make larger deductible contributions than you could to a traditional defined contribution plan, such as a SEP or Keogh profit-sharing plan. Ordinarily, traditional defined contribution retirement plans allow annual contributions that are limited to either:
- 25% of salary if you’re employed by your own S or C corporation, or
- 20% of self-employment income if you operate as a sole proprietor or single-member limited liability company (LLC).
Finally, traditional defined contribution plans are subject to a $56,000 cap on contributions to your account for 2019 (up from $55,000 in 2018).
Another upside of both SIMPLE IRAs and solo 401(k) plans is that annual contributions are discretionary. SIMPLE IRAs require mandatory matching contributions only if you make elective deferral contributions. If you don’t make an elective deferral contribution for the year, you don’t have to make a matching contribution either. So, you can contribute little or nothing in years when cash is tight.
Other advantages include the following:
Simplicity. You can quickly establish a SIMPLE IRA by filling out a form at most brokerage firms and financial institutions.
There’s no requirement to file annual reports with the federal government.
Simplicity. Establishing and operating a 401(k) plan means some up-front paperwork and ongoing administrative effort. But, with a solo 401(k), the administrative work is simplified because you’re the only participant. These plans are also exempt from the complicated nondiscrimination and coverage rules that can affect multiparticipant plans.
Plan loans. Within limits, you can borrow from a solo 401(k) account (assuming the plan document permits it, which you should insist on). The maximum loan amount is generally the lesser of $50,000 or 50% of your vested account balance.
There are also some potential downsides to SIMPLE IRAs and solo 401(k) plans.
Nonowner employees. If your business has other workers, you must let them participate in the SIMPLE IRA plan if the employee:
- Was paid at least $5,000 in any earlier year, and
- Is expected to be paid at least $5,000 during the current year.
The rules for employee elective deferral contributions and employer matching contributions are basically the same as the rules for owners. Plus, any matching contribution is immediately 100% vested. So, an employee can leave anytime without losing any of his or her employer matching contributions.
On the plus side, any required employer matching contributions will be relatively modest amounts, and no matching is required for employees who don’t make elective deferral contributions.
No loans. Borrowing from a SIMPLE IRA account is prohibited.
Nonowner employees. If your business has other workers, you may have to cover them with a more complicated multiparticipant 401(k).
However, the following workers are specifically excluded from the participation requirement:
- Employees who are under age 21, or
- Part-time employees who work less than 1,000 hours during any 12-month period.
If you employ only youngsters and part-time workers, you can effectively have a solo 401(k) that only benefits you. You also might consider using independent contractors, rather than hiring people full time, when possible.
Important: The annual elective deferral contribution maximum applies globally to all 401(k), 403(b) and SIMPLE IRA plans in which you participate. For 2019, the global elective deferral limitation is $19,000, or $25,000 if you’ll be 50 or older as of December 31, 2019.
For example, if you make a $10,000 elective deferral contribution to a 403(b) plan at your regular job, it reduces the elective deferral contribution that you could make to a solo 401(k) plan set up for your side business.
There’s still time to establish a SIMPLE IRA or solo 401(k) plan and then make deductible contributions for 2019.
SIMPLE IRA plans are maintained on a calendar-year basis. However, if you want to establish a SIMPLE IRA plan for 2019, you must do so by no later than October 1, 2019.
Solo 401(k) plans must be established by the end of the tax year for which the initial deductible contributions will be made. But, to make a valid elective deferral contribution, the plan must exist before the related self-employment income or compensation is deemed to have been earned.
For a calendar-year sole proprietorship or single-member LLC, this means the plan must be established by no later than December 31 of the year in question, because self-employment income is deemed to be earned on December 31.
A corporate plan must be established before the salary that will be used to fund employee elective deferral contributions has been earned. So, owner-employees of S and C corporations who delay setup until later in the year may be limited in their annual elective deferral contributions for 2019.
When deciding between a SIMPLE IRA and a solo 401(k) plan, the latter is generally the better option if you have substantial salary or self-employment income from your business and you want to make big contributions to a tax-favored retirement plan. If your business generates only a modest amount of income, a SIMPLE IRA plan may be the right choice.
If you can’t afford to contribute maximum amounts, consider a SEP IRA, another very simple type of retirement plan that’s geared toward small business owners. If you’re age 50 or older, you should also consider a defined benefit pension plan. Consult your tax professional for advice on which type of retirement plan is best for your specific circumstances.